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Essays on Government Intervention in Financial Crises
by
Danilo Lopomo Beteto
A Dissertation Presented to the
FACULTY OF THE USC GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements of the Degree
DOCTOR OF PHILOSOPHY
(Economics)
August 2013
Copyright 2013 Danilo Lopomo Beteto

This thesis studies the effects of government intervention in financial crises. In the first chapter it is analysed the effects of intervention for the formation of the network of banks, whereas in chapters 2 and 3 it is analysed the effects of intervention on asset prices. ❧ Chapter is divided in two parts. In the first one, government intervention is defined as a policy that allows banks to reduce fire sale costs, and an endogenous model of the formation of the network of banks is developed in a way that this type of intervention plays a key role in determining the structure of the banking system. The idea is that intervention brings incentives for banks to invest in more profitable but less liquid assets, which in turn can be financed only through interbank loans, which creates links across banks. In the second part of the paper, financial fragility is defined as the number of bank failures after banks' assets are hit by shocks, and under this measure networks obtained with and without intervention are compared. Theoretically it is shown that intervention makes the network of banks to be more connected, and from simulations that it brings more financial fragility despite increasing the wealth of the banking system. ❧ Chapter 2 studies the effect of a policy whereby intervention occurs only in financial crises where the welfare of investors goes below a specific threshold, to be called the safety net. The main question is how equilibrium prices differ under different intervention policies, and for that it is studied the investment decision problem of agents under two different frameworks, with and without intervention, and under three different informational scenarios, imperfect information, perfect information, and common priors. These informational scenarios are meant to capture different classes of assets where investors have varying degrees of knowledge regarding the technology embedded in the asset. It is shown that, regardless of the informational scenario, equilibrium prices can be sustained at a higher level in the framework with intervention than in the one without. However, equilibrium prices cannot be sustained at too much of high levels because, even though that would signal to investors that intervention would take place for sure, it still would not make investments profitable and, therefore, agents would prefer not to participate in the market, making the market clearing condition to fail to hold and an equilibrium not to exist. ❧ Chapter 3 studies the effects of a policy such that intervention occurs only in those financial crises where there is a significant drop in the level of prices. It is assumed that everyone knows the observed price of a particular asset, but only the government knows the fundamental price, the difference between the two being called a bubble. Nature defines if there will be a crisis or not and, every time there is one, the bubble bursts and the observed price drops to the fundamental. At this moment the government faces the cost of letting the bubble burst - proportional to the size of the bubble - and the cost of intervention, and by trading off the two it decides on its action. It is shown that, under such a policy rule, investors have incentives to inflate bubbles because by doing so they can make a higher capital gain if there is no crisis and, in case there is one, they increase the likelihood of intervention.

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Essays on Government Intervention in Financial Crises
by
Danilo Lopomo Beteto
A Dissertation Presented to the
FACULTY OF THE USC GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements of the Degree
DOCTOR OF PHILOSOPHY
(Economics)
August 2013
Copyright 2013 Danilo Lopomo Beteto